Beware These Unseen “Friction” Costs!!

May 21, 2013
May 21, 2013

Brokers, placement agents, middle men, promoters, consultants, financial intermediaries…call them whatever you wish. They have existed in the financial space since man invented a way to exchange one thing of value for another.

Some do a fine job, provide a valuable service and deserve every penny they earn. In my experience however, and that of Mark and many of our friends who invest in private equity, these people, the deserved ones that is, are a very small fraction of those inhabiting this space. I’ve met hundreds of middle men and can count on one hand those I trust and value.

In the private equity space they are abundant. MAN are they abundant. In fact, I think we currently have a bubble in middle men. Doubt me? Hop onto LinkedIn and you’ll find every Tom, Dick and Sheryl hard at work putting Nigerian scam artists to shame. To be fair, they may represent real deals which in-and-of-themselves are not shams, but beware the costs. Many “represent” millions in capital, yet like those “trusty” Nigerians, who also represent gobs of dough, somehow they just need that little itty-bit of additional capital from you and I to “pull it over the line.”

I bring this up because of an amusing interaction I had recently with one such individual. I’d like to think that shining a light on some of these creatures lurking under slimy rocks may help other investors recognize these clowns when they see them. It may also serve as one of the red flags I previously spoke about for investors seeking an entrance into private equity deals.

Firstly, you’ll likely have already come across some of them; they’re quite possibly the guys “endorsing” you for your skills on LinkedIn. WTF..?

I’m confused, some guy I’ve never met and don’t know from Adam, just endorsed me for “Strategic financial planning” skills. As confusing as this is, what really gets me is why I’ve not been endorsed for my great pancake making skills. My kids reckon I’m the best there is, and they actually know me and have witnessed said incredible pancake making abilities. The guy on LinkedIn…not so much!

Now these guys are nothing like brokers at all, but rather more akin to back alley abortionists peddling their wares, complete with the rusty, blood-stained “tools” from the last botched job. They litter the world of private equity like plastic bags on a Maputo high street, and frankly annoy the sh*t out of Mark and I.

A story to illustrate absurdity…

Onto my tale. I was recently put in touch with a gentleman of the type I described above, it turned into the stuff of high comedy.

Now, the underlying business was actually OK, which was why I gave the time of day to him to further explain the deal terms. However, the structure of the deal was such that the “promoter” got a fat chunk of the cash out of the gate, travel expenses (which were obscene), and sundry other expenses, which I showed to Mr. back alley boy, that amounted to fully 60% of the investors capital! I kid you not! Even more amazing to me is that this clown had in fact already found an investor of sufficiently low intellect to invest in the deal, taking out the majority of the offering. A 7-figure sum. I pity the sod. Something about “fools and their money” comes to mind.

This particular investor now requires a 150% return in order to simply break even. This, on an investment which is high risk to begin with, and where it’s entirely possible to lose 100% of his money. Of course the promoter was doing his damndest to make the deal sound like a low risk, HUGE upside, fit for widows and orphans opportunity. He tried to weasel his way out of the facts when I presented them to him, but I was having none of it. In frustration he simply walked away saying I didn’t understand the deal. Oh, I understood…and that of course was the problem.

This was one of the more extreme cases I’ve seen of friction costs, but I will say that it’s pretty common for your investment dollar to be “attritioned” or “frictioned” to the tune of 15% or more on many deals I’ve reviewed. On a $100,000 placement you’re looking at losing $15,000 right out of the gate if you don’t pay attention.

You will almost NEVER be shown these details, but will need to closely examine the deal to find them out. Small print etc. folks. Look for font size 8 and read diligently.

As an investor it’s crucial to understand the cost of capital for any business you are looking at getting involved in. Additionally, ferreting out the true cost of capital for a business, and whether you are getting hosed or not, is important in order to understand the true state of accounts in the company.

Some points:

Find out how much capital hits the balance sheet. Unless its a “friends and family” round you’ll likely have placement fees somewhere. No problem, but analyze them and make sure that they make sense.

Always ask whether they have their own capital on the line, how much, and ask for proof and full disclosure of compensation to those involved in the transaction. Let me tell you there is a vast, Grand Canyon wide difference between having your own cash on the line and that of a client, friend, associate, or whatever you want to call “the other guy”… you know, the one who is actually putting up the capital.

Kyle Bass mentions the, “give a shit factor”, and it is remarkably high when putting your own cash on the line. I should know, I’ve been “dumb enough” my entire adult life to be the guy putting his own capital to work and only getting paid when I’m right, and taking it on the chin when I’ve screwed up. It has frustrated me many times to have watched middle men walk away with larger sums than I…even after they never put a single dime on the line. No need to follow my path though, you can always become a mini-Bankster yourself.

Good luck out there, watch ceaselessly for this nonsense and make sure you ask the question first and foremost if any fees are being paid and to whom. Full disclosure should be given. So, next time some back alley abortionist lies to you, do us all a favour and punch them in the face.